Walter's Theory on Dividend Policy

Walter’s model on dividend policy believes in the relevance concept of a dividend. According to this concept, a dividend decision of the company affects its valuation. Walter’s theory further explains this concept in a mathematical model.

Crux of Walter’s Model

Prof. James E Walter formed a model for share valuation that states that the dividend policy of a company affects its valuation. He categorized two factors that influence the price of the share, viz. dividend payout ratio of the company and the relationship between the internal rate of return of the company and the cost of capital.

Relation of Dividend Decision and Value of a Firm

According to Walter’s theory, the dividend payout in relation to (Internal Rate of Return) ‘r’ and (Cost of Capital) ‘k’ will impact the value of the firm in the following ways:

Relationship between r and k Increase in Dividend Payout Decrease in Dividend Payout
r>k Value of the firm decreases Value of the firm increases
r<k Value of the firm increases Value of the firm decreases
r=k No change in the value of the firm No change in the value of the firm

Assumptions of Walter’s Model

Walter’s model is based on the following assumptions:

Internal Financing

The firm finances all the investments through retained earnings. No new equity is issued for the same.

Constant IRR and Cost of Capital

The internal rate of return (r) and the firm’s cost of capital (k) is constant. The business risks remain the same for all investment decisions.

Constant EPS and DPS

Beginning earnings and dividends of the firm never change. Though different values of EPS and DPS may be used in the model, they are assumed to remain constant while determining a value.

Infinite Life

The company has an infinite or very long life.

Walters Theory on Dividend Decisions

Capital Market is Perfect

It means that information about all securities is available to all investors in equal proportion. Due to this assumption, there is no overpricing or underpricing of the security. Further, it means that all investors are rational. It means all investors want to increase their returns and reduce their risk.

No Flotation Cost, No Transaction Cost, No Corporate Dividend Tax

It is assumed that there is no cost to the company in issuing the security, there is no cost to investors to buy or sell a security, and there is no corporate dividend tax. All of them have been eliminated because these things do not remain the same for all companies, and this theory is to be applied universally.

Only Equity Finance

A company can have only equity finance. It includes equity share capital & reserves, and surplus. There is no source of finance like preference share capital or debentures. Preference share capital is a hybrid source of finance; it includes certain features of debt and certain features of equity. So, it is eliminated by making this assumption.

Further, in the case of debt financing, there is a chance of trading on equity, so with that earning rate, the company will keep on changing. Hence it is also eliminated. Trading on equity means borrowing at a lower rate and earning at a higher rate.

Walter’s Model Valuation Formula and its Denotations

Walter’s formula to calculate the market price per share (P) is:

P = D/k + {r*(E-D)/k}/k, where

P = market price per share

D = dividend per share

E = earnings per share

r = internal rate of return of the firm

k = cost of capital of the firm

Explanation: The mathematical equation indicates that the market price of the company’s share is the total of the present values of:

  • An infinite flow of dividends, and
  • An infinite flow of gains on investments from retained earnings.

The formula can be used to calculate the share price if the values of other variables are available.

A company has an EPS of Rs. 15. The market rate of discount applicable to the company is 12.5%. Retained earnings can be reinvested at an IRR of 10%. The company is paying out Rs.5 as a dividend.

Calculate the market price of the share using Walter’s model.


D = 5, E = 15, k = 12.5%, r = 10%

Market price of the share = P = 5/.125 + {.10 * (15-5)/.125} /.125 = 104

Implications of Walter’s Model

Walter’s model has important implications for firms in various levels of growth as described below:

Growth Firm

Growth firms are characterized by an internal rate of return > cost of the capital, i.e., r > k. These firms will have surplus profitable opportunities to invest. Because of this, the firms in the growth phase can earn more return for their shareholders in comparison to what the shareholders can earn if they reinvested the dividends somewhere else. Hence, for growth firms, the optimum payout ratio is 0%.

Normal Firm

Normal firms have an internal rate of return = cost of the capital, i.e., r = k. The firms in the normal phase will make returns equal to that of a shareholder. Hence, the dividend policy is of no relevance in such a scenario. It will not influence the market price of the share. So, there is no optimum payout ratio for firms in the normal phase. Any payout is optimum.

Declining Firm

Declining firms have an internal rate of return < cost of the capital, i.e., r < k. And they make returns that are less than what shareholders can make on their investments. So, it is illogical to plowback the company’s earnings. In fact, the best scenario to maximize the share price is to distribute entire earnings to their shareholders. The optimum dividend payout ratio, in such situations, is 100%.

Criticism of Walter’s Model

Walter’s theory is critiqued for the following unrealistic assumptions in the model:

No External Financing

Walter’s assumption of complete internal financing by the firm through retained earnings is difficult to follow in the real world. The firms do require external financing for new investments.

Constant r and k

It is very rare to find the internal rate of return and the cost of capital to be constant. The business risks will definitely change with more investments that are not reflected in this assumption.

Conclusion of Retaining 100% of Earning

Conclusion of Walter Model that, if r exceeds ke, retaining 100% of earning is unrealistic. Considering dividend payments by other companies, it is necessary to make equity dividend payments; otherwise, the company’s stock will be out of favor. Cash return will give psychological more satisfaction than a change in the price of the security.

Other Unrealistic Assumptions

Assuming that there is no debt financing, preference share capital financing, no flotation cost, transaction cost, the capital market is perfect are impractical assumptions.


Though Walter’s theory has some unrealistic assumptions, it follows the concept that a company’s dividend policy affects the market price of its share. It explains the impact in mathematical terms and finds the value of the share.

Sanjay Borad

Sanjay Bulaki Borad

MBA-Finance, CMA, CS, Insolvency Professional, B'Com

Sanjay Borad, Founder of eFinanceManagement, is a Management Consultant with 7 years of MNC experience and 11 years in Consultancy. He caters to clients with turnovers from 200 Million to 12,000 Million, including listed entities, and has vast industry experience in over 20 sectors. Additionally, he serves as a visiting faculty for Finance and Costing in MBA Colleges and CA, CMA Coaching Classes.

4 thoughts on “Walter's Theory on Dividend Policy”

  1. If ROI is constant then EPS can never be constant as additional earnings are earned due to retained earning financing. So, EPS remaining constant when ROI is constant is mathematically wrong assumption.

  2. Thanks sir, it is very simple explanation. I was not able to understand this concept form book of I M Pande financial management. Best of luck sir


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